Q&A: Keeping retirement money in various accounts helps with tax bills

Dear Liz: I am having difficulty determining if I should invest money in my 457 deferred compensation account or in a taxable account, as I am in the 15% tax bracket.

Also, does it matter whether I invest in a Roth IRA instead of my traditional IRA? My biggest pot of money is in a taxable account, then my IRA, then a Roth. I am single, no dependents and over 50.

Answer: In retirement, having money in different tax “buckets” can help you better control your tax bill.

Taxable accounts, for example, can allow you to take advantage of low capital gains tax rates plus you can withdraw the money when you want: There are no penalties for withdrawals before age 59½ and no minimum distribution requirements.

Tax-deferred accounts allow you to save on taxes while you’re working but require you to pay income taxes on withdrawals — and those withdrawals typically must start after you turn 70½.

Roth IRAs, meanwhile, don’t have minimum distribution requirements, and any money you pull out is tax free, but contributions aren’t tax deductible.

Because most people drop to a lower tax bracket in retirement, it often makes sense to grab the tax benefit now by taking full advantage of retirement accounts that allow deductible contributions.

That means the 457 (generally offered by governmental and nonprofit entities) and possibly your regular IRA. (Your ability to deduct your IRA contribution depends on your income, since you’re covered by the 457 plan at work.)

If your IRA contribution isn’t deductible, then contribute instead to a Roth. If you still have money to contribute after that, use the taxable account.

If you expect to be in the same or higher tax bracket in retirement, though, consider funding the Roth first. Prioritizing a Roth contribution also can make sense if you have plenty of money in other retirement accounts and simply want a tax-free stash you can use when you want or pass along to heirs.

Q&A: Figuring out capital gains when an inherited house is sold

Dear Liz: I’ve have been following your responses related to the tax exemption on home sales. I understand that up to $250,000 per person of home sale profit is exempt from capital gains taxes and that married couples are entitled to exempt up to $500,000.

My spouse and her two siblings inherited a home from their parents. My father-in-law passed away four years ago, and my mother-in-law died last year. My wife was assigned as executor of their living trust. Who is entitled to take the tax exemption of the proceeds from the sale of the house? My wife? All three siblings? All of the above and their spouses?

Answer: None of the above, but don’t despair because the house will incur little if any capital gains when it’s sold.

We’ll assume your mother-in-law inherited the house outright from her husband, since that’s usually the case. When your mother-in-law died, the house received a “step up” in tax basis to reflect its current market value. If the house was worth $2 million when she died, for example, that’s the new value for tax purposes — even if she and your father-in-law paid only $25,000 decades ago for the house. All the gain that occurred in between their purchase and her death won’t be taxed.

If your wife sells the house for $2.2 million, there potentially would be some taxable capital gain. But the costs of marketing and selling the home would be deducted from its sale price. If those costs are 6% of the sale price — which is a pretty conservative assumption — the taxable gain would be about $68,000. (Six percent of $2.2 million is $132,000. Subtract the $2 million value at death and the $132,000 of sales costs, and you’re left with $68,000.) If your wife as executor sells the house and distributes the proceeds to the beneficiaries, the estate would pay the tax. If siblings inherit the house and then sell it, they would pay any tax.

Every year, millions of dollars of potential capital gain vanish this way as people inherit appreciated property. It’s a huge benefit of the estate tax system that many people don’t understand until they’re the beneficiaries of it.

Q&A: Capital gains

Dear Liz: If and when we sell our house, the capital gain is likely to exceed the $500,000 exemption limit. I am carrying over a loss of about $100,000 from stock sales. Can I use this loss to offset the capital gain from the house?

Answer: Yes. Capital losses can be used to offset capital gains, including those from a home sale.

Q&A: Deducting medical expenses racked up by another person

Dear Liz: I recall reading that an individual could deduct unlimited medical expenses for another person, as long as the provider was paid directly. Looking at IRS Publication 502, it appears that now only a “qualifying relative” (the closest I could get to eligibility) is eligible for a deduction on another person’s return. I’m asking because my sister is helping with my medical expenses, and I had hoped to give her a deduction. Her tax person is insistent that she cannot take a deduction for my expenses. I don’t qualify under the “qualifying relative” clause because she doesn’t provide more than half my support. Have I always misinterpreted this rule, or has the rule changed recently?

Answer: You’re confusing the medical deduction rules with the gift tax exemption.

The gift tax rules require givers to file tax returns for gifts in excess of $14,000 per recipient, unless the giver paid medical or tuition expenses directly to a provider (such as a hospital or college). Paying these expenses isn’t considered a gift, so your sister can pay an unlimited amount of your medical bills without having to file a gift tax return or counting those gifts toward her lifetime exclusion amount, which is currently $5.49 million. Gift taxes aren’t owed until that lifetime exclusion amount is exceeded.

Your sister can deduct medical expenses from her income taxes only when she pays them on behalf of herself, her spouse, her dependents and her “medical dependents.” Claiming someone as a dependent or medical dependent requires that she provide at least half that person’s support. Only the amount of qualifying medical expenses that exceed 10% of her adjusted gross income in 2017 would be deductible.

Q&A: When generosity becomes a taxing issue

Dear Liz: I recently came into some money, and I would like to share it with my family. I understand that there are annual tax caps on how much you can give to someone ($14,000 per person per year). However, does this limit apply only to cash and cash equivalents or also to any other gifts? For instance, can I pay off a sibling’s student loan for more than $14,000 without running afoul of the limits?

Answer: There’s no cap on how much money you can give to another person. But if you give more than $14,000 to any one person, you have to file a gift tax return (IRSForm 709). You won’t actually owe gift taxes until the amount you give in excess of that limit totals more than $5 million. (The precise limit this year is $5.49 million and it’s scheduled to rise by the rate of inflation in coming years.)

Paying most bills, including student loans, on behalf of another person counts as part of that $14,000 limit. The only exceptions are if you pay someone’s tuition, medical expenses and health insurance. To avoid the limit, you would have to pay the bills directly to the provider (such as the school, doctor, hospital, insurance company and so on). If you give the money to the person to pay these expenses, it counts as part of the $14,000 exemption.

Some people keep rigidly to the $14,000 limit to avoid having the excess gifts reduce their estate tax exemption. (Gifts over the $14,000 limit are added back into a person’s estate at death, and the prevailing estate tax exemption — which is also currently $5.49 million — is deducted from that enhanced total.)

If you aren’t a multimillionaire, though, this probably isn’t something you need to worry about. If you go over the $14,000 per person limit, you just have to deal with a little paperwork.

Q&A: Capital gains taxes explained

Dear Liz: Do I understand correctly that I must live in a house for two years before selling it to avoid paying capital gains tax, regardless of how much I may profit from the sale?

Answer: You do not. You must live in a home for two of the previous five years to exempt up to $250,000 of home sale profits. (Married couples can exempt up to $500,000.) After that, you’ll pay capital gains taxes on any remaining profit.

Even if you didn’t last the full two years, you may be able to claim a partial exemption if you meet certain criteria, such as having a change in employment, a health condition or other “unforeseen circumstance” that required you to move out.

Q&A: Capital gains tax on home sale profit

Dear Liz: I recently sold a home and am trying to escape the dreaded capital gains tax. I’ve done everything I can to reduce my overall tax bill, including maxing out my retirement contributions. I don’t want to buy a more expensive home to escape the gains tax. Any thoughts?

Answer: Buying a more expensive home wouldn’t change what you owe on your previous home. The days when you could roll gains from one home purchase into another are long gone.

These days you’re allowed to exclude up to $250,000 in home sale profit from your income (the limit is per person, so a couple can shelter $500,000). In other words, that amount is tax free, as long as you lived in the home for at least two of the previous five years. Beyond that your profit is subject to capital gains taxes. The top federal capital gains rate is 20%, plus a 3.8% investment surtax if your income is more than $200,000 for singles or $250,000 for married couples.

Here’s where good record-keeping may help. While generally you’re not allowed to deduct repair and maintenance costs from that profit, you can use home improvement expenditures to reduce the tax you owe. Home improvements are added to your cost basis — essentially what you paid for the property, including settlement fees and closing costs, and that’s what is deducted from your net sales price to determine your profit.

You’ll need receipts plus credit card or bank statements to prove what you paid. Improvements must “add to the value of your home, prolong its useful life, or adapt it to new uses,” according to IRS Publication 523, Selling Your Home. Examples of improvements include additions, remodels, landscaping and new systems, such as new heating or air conditioning systems. You can include repairs that are part of a larger remodeling job, but you can’t include improvements you later take out (such as the cost of a first kitchen remodel after you do a second one).

4 tax hacks you might not know

You know to contribute enough to your 401(k) to get the full company match. Maybe you’ve even adjusted your withholding so you’re not giving Uncle Sam an interest-free loan.

Yet you may feel the need to do even more, especially if you’re making the last big push toward retirement. These hacks allow you to shelter more money from taxes now and when you retire. In my latest for the Associated Press, the 4 crucial tax hacks you might not know.

Q&A: Credits can boost a refund beyond the taxes paid — and keep millions out of poverty

Dear Liz: A friend of mine received a 2016 tax refund of over $9,000 even though this person did not pay nearly that amount in taxes over the course of the year. My friend has a fairly low-paying job with no benefits, is a single parent of two young children and receives no support from the children’s other parent. Given this scenario, is it possible to get a tax refund in an amount greater than what you paid in taxes?

Answer: Absolutely, and these refundable credits keep millions of working Americans out of poverty each year.

Refundable credits are tax breaks that don’t just offset taxes you owe but also can give you additional money back. Most of your friend’s refund probably came from the earned income tax credit, which was initially created in the 1970s to help low-income workers offset Social Security taxes and rising food costs due to inflation.

The credit was expanded during President Reagan’s administration as a way to make work more attractive than welfare. Each administration since has increased the credit, which has broad bipartisan support.

The maximum credit in 2016 was $506 for a childless worker and $6,269 for earners with three or more children. Your friend probably also received child tax credits of up to $1,000 per child. This credit, meant to offset the costs of raising children, is also at least partially refundable when people work and earn more than $3,000.

Q&A: The give and take of federal gift tax rules

Dear Liz: We are planning to build an addition to our home so that my mom can move in with us and will take out a loan to pay for it. Let’s say that we put down $50,000 and take out a loan for the remaining cost of $150,000. After the addition is built, my mom will sell her house and with the proceeds she will give us $200,000 to pay for the cost of the addition. Is this considered a gift? Or is it considered payment for a place to live (i.e. she gets something in return), and therefore it is not a gift?

Answer: What do you want it to be?

If you want it to be a gift, then it certainly can be. If your mother wanted to give you the money all at once, she would need to file a gift tax return because the amount exceeds the $14,000 per recipient annual exclusion. But she wouldn’t need to pay gift tax until the amount she gives away in excess of the annual exclusion reaches a certain limit (which is $5.49 million in 2017).

Gifts in excess of the annual exclusion also affect how much of a wealthy person’s estate can pass tax-free to heirs. If your mother is worth more than about $5 million, she should consult an estate planning attorney before making any gifts.

If she doesn’t want to bother with a gift tax return, she could give you and your spouse $14,000 each, or $28,000, per year until she’s given the $200,000.

If you or your mother prefer to make payments over time and treat the money as rent, you would need to declare the income. You could write off certain rent-related expenses, such as a portion of insurance premiums and repairs, that wouldn’t be deductible otherwise, plus you’d get another tax break from depreciating the portion of the property that’s considered a rental.

But that could trigger a big tax bill when you sell the home, so make sure you run this plan past a tax pro who can help you weigh the costs and benefits.